We're headed for 1938 all over again

A
photo from the federal government's campaign to document the
Great Depression.Wikimedia
Commons

Let's start with a quick history lesson.

Coming out of the depth of the Great Depression, the late 1930s
ushered in a time when the US seemed to be back on stable
footing.

The New Deal, a massive stimulus plan from president Franklin D.
Roosevelt, had spurred growth and dropped unemployment from
startling highs.

Unfortunately, private investment was struggling and inflation
remained on the low side. Psychologically scarred by the economic
drop-off, people decided to pay down debt in their ledgers rather
than go out and spend. Encouraged by the seemingly strong
economy, the government
began to back off the fiscal stimulus and tighten financial
policy.

Sound familiar?

Well it should, says the Morgan Stanley global strategy team
of Chetan Ahya, Elga Bartsch, and Jonathan Ashworth. In fact, the
team said in a note to clients Wednesday that nearly the same
situation that occurred in 1937-38 is currently happening in the
US.

"The critical similarity between the 1930s and the 2008 cycle is
that the financial shock and the relatively high levels of
indebtedness changed the risk attitudes of the private sector and
triggered them to repair their balance sheets," wrote Ahya,
Bartsch, and Ashworth.

"During the deleveraging process, the private sector becomes
risk-averse and shifts its attention towards restoring health to
its balance sheets."

And how did this cautious, low demand attitude end in the early
20th century?

Disastrously, in fact, as the private investment
couldn't replace public investment, inflation expectations
plummeted and deflation rocked the economy into a double-dip
recession. Unemployment rose again, and the economy went back to
struggling.

"In 1936-37, the premature and sharp pace of tightening of
policies led to a double-dip in the US economy, resulting in a
relapse into recession and deflation in 1938," the Morgan Stanley
team wrote.

"Similarly, in the current cycle, as growth recovered,
policy-makers proceeded to tighten fiscal policy, which has
contributed to a slowdown in growth in recent quarters."

Morgan
Stanley

This same atmosphere is happening today as the federal government
has tapered its support of the economy, and the Federal Reserve
is beginning on
a path of higher interest rates. This path forward so far,
the team said, has shown all of the wobbles of the late 1930s.

"The sluggish private demand and weakening inflation expectations
are signs that the repair process for the private sector’s
balance sheets is not yet complete," the note said. "If global
growth stays weak for longer, the corporate sector will have to
continuously adjust down its return expectations, leading to a
negative feedback loop."

All is not lost for the people of today, according to the
strategists. In fact, a few simple policy solutions could be
implemented to avoid the mistakes of the past.

"Activating fiscal policy, particularly at a time when the
monetary policy stance is still accommodative, could lead to a
virtuous cycle where the corporate sector takes up private
investment, and sustains job creation and income growth," the
strategists wrote.

To make sure that these policies have taken hold, the Morgan
Stanley team said that inflation expectations have to recover.
Currently, most forward-looking measures of inflation — from the
University of Michigan's
household survey to the five-year/five-year inflation
expectation —
are trending downward.

Even yesterday, Fed Chair Janet Yellen was asked about these
perpetually low and falling expectations, and she said she was
watching them closely.

According to Ahya, Bartsch, and Ashworth,
Yellen and the rest of the government have a lot do to to raise
them, or we could end up repeating a sad part of US economic
history.